One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand UGI Corporation (NYSE: UGI).
Return on Equity or ROE is a test of how effectively a company increases its value and manages investors’ money. In simple terms, it is used to assess the profitability of a company in relation to its equity.
See our latest analysis for UGI
How is ROE calculated?
the ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for UGI is:
27% = US$1.5 billion ÷ US$5.5 billion (based on trailing 12 months to September 2021).
“Yield” is the income the business has earned over the past year. This means that for every dollar of shareholders’ equity, the company generated $0.27 in profit.
Does UGI have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. As the image below clearly shows, UGI has a better ROE than the average (9.7%) for the gas utility industry.
That’s what we like to see. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. Besides changes in net income, a high ROE can also be the result of high debt to equity, which indicates risk. Our risk dashboard should contain the 2 risks we have identified for UGI.
What is the impact of debt on return on equity?
Companies generally need to invest money to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not change equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
UGI’s debt and its ROE of 27%
UGI uses a high amount of debt to increase returns. Its debt to equity ratio is 1.22. Its ROE is quite impressive, but it probably would have been lower without the use of debt. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, I would generally prefer the one with less debt.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. You might want to take a look at this data-rich interactive chart of the company’s forecast.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.